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Using Insurance to Ensure the Smooth Sale of Your Business

The imaginative ways that insurance can be used to facilitate the sale of a business are not widely known. Gesmer Updegrove LLP and Mazonson, Inc. (a Massachusetts insurance broker) recently used insurance to good effect to facilitate the sales of two software companies. This article, which is based on those transactions, uses a hypothetical transaction to illustrate the techniques used by our firm and Mazonson on behalf of those companies. While the example provided here is somewhat specific, there are a variety of ways sophisticated legal counsel and insurance brokers can make effective use of insurance in the context of mergers and acquisitions.

THE OPPORTUNITY

A publicly traded Fortune 100 corporation, BuyInc, approaches you, the founder of SellCo, a privately held software company, in regard to the acquisition of your business. BuyInc makes it clear that its primary interest is in your intellectual property, as SellCo has little revenue. You are thrilled at the prospect of joining forces with BuyInc, and enter into discussions regarding the material terms of the transaction under an appropriate nondisclosure agreement. However, as you will soon discover, the current market climate has led to an increased level of scrutiny by buyers, along with an unwillingness to accept more than minimal risk in association with a business acquisition. The higher level of scrutiny by the potential buyer for your company will pose a significant obstacle to the sale.

STRUCTURE & NEGOTIATIONS

BuyInc and SellCo agree upon a purchase price of $10 million. Of that, $9 million will be paid to SellCo at closing with $1 million held in escrow to secure SellCo’s indemnification obligations. The purchase and sale agreement will contain representations and warranties made by SellCo and you, as its founder. If, after the closing of the transaction, BuyInc discovers that any of SellCo’s or your representations were inaccurate when made, then SellCo and you will indemnify BuyInc (that is, you will be responsible for the payment of any losses BuyInc incurs in connection with the misrepresentation). Your lawyer advises you to limit potential liability through the use of: (1) a threshold claims amount (the minimum amount of damages that must be incurred by BuyInc before it can seek indemnification from SellCo); (2) a limited survival period for the representations and warranties; and (3) a liability cap (a maximum amount which SellCo would be required to pay to BuyInc).

SellCo successfully negotiates a threshold: the parties agree that BuyInc will be responsible for payment of the first $100,000 worth of claims. The parties agree that claims based on misrepresentation will survive only until the second anniversary of the closing date. SellCo and its founder negotiate a cap on potential liability in the amount of $750,000. However, there is one aspect of the negotiation that is not easily resolved: BuyInc insists that it will not accept any risk associated with the purchase of SellCo’s intellectual property. BuyInc requires an express exception to the liability cap: with respect to any misrepresentation regarding intellectual property, SellCo’s liability (and your potential liability as its founder), must equal the purchase price. In addition, BuyInc insists that claims based on misrepresentations related to SellCo’s intellectual property must survive for a period of six years. You believe the sale of SellCo to BuyInc presents an attractive opportunity, but you are seriously concerned about BuyInc’s indemnification requirements regarding intellectual property representations.

Although SellCo has never been accused of infringing another’s intellectual property rights, you recognize that competitors might be motivated to make allegations of intellectual property infringement following the sale of SellCo to BuyInc, due to BuyInc’s large size and deep pockets (at least when compared to SellCo). You are reluctant to accept the greater risk demanded for the intellectual property representation as compared with the other representations regarding SellCo’s business. After BuyInc tells you that it is unwilling to reduce its demand with respect to intellectual property indemnification, it appears that your negotiations with BuyInc may be at an impasse.

AN INSURANCE SOLUTION

To moderate your concerns and assist in moving negotiations forward, your legal counsel introduces you to an insurance broker specializing in mergers and acquisitions (M&A) transactions in order to explore possible insurance solutions. The insurance broker recommends that SellCo and you transfer the risk of breach of all the representations and warranties, including the proposed intellectual property indemnification, to a seller-based reps and warranties policy. Your legal counsel and insurance broker work together to create a Representations and Warranties (R&W) Liability Insurance policy that mirrors the terms of the transaction and mitigates the risks of both parties. The policy is designed with a $10 million limit to match the purchase price and liability cap, and a $100,000 deductible to match the threshold. Under this model, you would pay nothing in the event of an unintentional misrepresentation, as the policy is structured to pay dollar-one after the threshold/deductible (absorbed by BuyInc) is exhausted. The policy does not recognize the escrow provision, thus protecting the escrowed funds in the event of a covered claim. You choose the maximum policy period: six years for the intellectual property representations and two years for all other representations and warranties. The premium is $350,000. Realizing that R&W Liability Insurance is critical to bridge the impasse in negotiations, BuyInc agrees to pay half the premium.

THE DIFFERENCE IN DOLLARS

Assume that, after the closing, a third party sues BuyInc for intellectual property infringement relating to SellCo’s business, and that the party claims damages in the amount of $1.1 million. Without R&W Liability Insurance, BuyInc would be responsible for the first $100,000 of the claim, and SellCo would forfeit the $1 million held in escrow to satisfy BuyInc’s indemnification claim. SellCo’s net proceeds from the sale of the business would be $9 million. With R&W Liability Insurance, BuyInc also would be responsible for the first $100,000 of the claim, and SellCo would forfeit the $1 million held in escrow in order to satisfy BuyInc’s indemnification claim. However, SellCo would receive $1 million of insurance proceeds. SellCo’s net proceeds from the sale of the business would be $9,825,000 ($10 million minus $175,000 (one-half the insurance premium)).

WIN/WIN

Secure in the knowledge that the insurance policy will compensate you in the event of a claim, SellCo comfortably accepts BuyInc’s strict conditions in association with the intellectual property representations. Both BuyInc and SellCo have achieved their transaction goals and are able to work together as a combined entity. R&W Liability Insurance is in place for SellCo and you, and the sale of the business closes within five days after the seeming impasse.

CONCLUSION

In this scenario, the negotiation process would have been stalemated without R&W Liability Insurance, and the sale of SellCo to BuyInc would not have materialized. Beyond R&W Liability Insurance, M&A insurance policies can be designed to protect buyers or sellers, reduce or eliminate the need for an escrow fund, achieve higher purchase prices, and lead to the closure of deals that otherwise might have been be abandoned.

Consult with an experienced M&A attorney and, together, engage the services of an insurance broker specializing in the M&A field to explore the use of a properly designed insurance policy to augment your negotiation strategies.